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Legal Briefing

Corporate and commercial | 01 April 2011

Where a contract is formed on the basis of a mistake as to the law or certain facts, the contract can potentially be deemed void from its inception. In certain circumstances, however, the court has the authority to remedy the mistakes, by construing the contract in a way that will correct the mistakes, or by rectification.

In the recent Fairstate Ltd v General Enterprise & Management Ltd & anor [2010], the High Court considered whether a personal guarantee could be corrected either by rectification or by construing its terms to give effect to the parties’ intentions. Fairstateclarifies the scope of the court’s powers of rectification and construction.

DOCTRINE OF MISTAKE

The doctrine of mistake in contract law encompasses both mistakes of law and mistakes of fact. Broadly speaking, there are three types of mistake of fact:

common mistake – where both parties make the same mistake based on a shared misconception of an underlying fact;

unilateral mistake – where one party makes a mistake and the other party has knowledge of the mistake; and

mutual mistake – where the parties are at cross-purposes and suffer a genuine misunderstanding.

It is also possible for the courts to order relief for a contractual mistake of law. For example, if money is paid under a contract based on a legal provision that has subsequently been repealed, the court can provide a remedy to the paying party.

The danger of forming a contract on the basis of a mistake, is that the court can either declare the contract void, or make a determination of how the contract should be construed or amended. Considering the uncertainty of the latter options, it is useful to be aware of the scope of the court’s power.

REMEDY BY CONSTRUCTION

If there is an obvious drafting mistake in a contract, the court can construe the contract in a way that will correct the mistake, provided it is a clear mistake on the face of the contract, and it is obvious what correction is required to remedy the deficiency.

The court’s interpretation of a contract should be on an objective basis. The question is what meaning the:

‘Document would convey to a reasonable person having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract’.1

Where the court is required to interpret contractual terms, the ‘parol evidence rule’ states that evidence cannot be admitted to add to, vary or contradict a written agreement. Therefore, extrinsic evidence, such as written evidence of pre-contract negotiations, is not admissible for ascertaining the parties’ intentions.

REMEDY BY RECTIFICATION

Rectification is an equitable remedy employed at the court’s discretion when looking at a written contract. The remedy is available where there has been a mistake in effectively recording the terms agreed between the parties. If a contract fails to reflect the parties’ intentions, the court can rectify it by ordering its wording to be changed.

Rectification can also be used where the parties use terminology that has a different legal effect from that intended. Rectification will only be ordered by the court if there is a live dispute between the parties and it is therefore necessary for the court to do so. In addition to rectification for failure to reflect agreed terms, a claim for rectification can be made where a person unintentionally signs a contract in the wrong capacity.

The burden of proof to show that the terms agreed between the parties are not reflected in the contract is on the party seeking rectification. The evidential burden is high, because if the court makes an incorrect order for rectification, it can potentially impose terms on a party that were not agreed or intended. Most importantly, the court’s power can also undermine the certainty of contractual terms. The party seeking rectification must therefore provide strong and convincing evidence that the document failed to record the intention of the parties. Oral evidence alone is unlikely to be sufficient, so written evidence of the pre-contract negotiations can be crucial to overcoming the evidential burden. The ‘parol evidence rule’ does not apply to rectification, which by its nature requires an assessment of the subjective intention of the parties.

The general rule is that a contract can only be rectified if there is a common mistake, that is to say where the recorded contract has failed to fulfil the intention of both parties. For example, where a buyer and seller agree to the sale of 5kg of sugar for £5, and this is clear from the pre-contract negotiations, but the formal contract states that the sale is for £10. However, if the seller always intended for the sugar to be sold for £10, there is a unilateral mistake, and the court cannot rectify the contract because it would, in effect, force the buyer to enter into a contract to which it had never agreed or intended. There is, however, an exception to this rule, whereby rectification can apply to a unilateral mistake if it can be demonstrated that there was unconscionable behaviour on the part of the seller. For example where the party was guilty of fraud or misrepresentation.

The court may also rectify the contract where a party had knowledge of the mistake, but failed to communicate the knowledge to the other party. Knowledge for these purposes includes actual knowledge, wilfully shutting ones eyes to the obvious, or failing to make such inquiries as an honest and reasonable person would make.

FAIRSTATE

The scope of the court’s power to remedy deficiencies in a contract, by way of rectification and construction, has recently been clarified in Fairstate.

FACTS

In Fairstate, the claimant (Fairstate), the owner of a block of residential flats, entered into a management agreement with the defendant company General Enterprise & Management Ltd (GEML). At the same time, the second defendant, the director of GEML (Atef Sarian), signed a personal guarantee (the guarantee). As a preliminary issue, the court was asked to consider whether Sarian was liable to Fairstate under the guarantee.

It was submitted by Sarian that the guarantee was not sufficient to satisfy s4 of the Statute of Frauds Act 1677 (the 1677 Act), alternatively the guarantee was not effective due to the volume of mistakes. In particular, it did not identify:

Fairstate as the creditor;

GEML as the principal debtor; and

the management contract as the obligation to be secured.

In addition, it was generally expressed in terms that were appropriate to a banking transaction rather than a commercial one. Fairstate submitted that Sarian was estopped from denying there was an effective guarantee, and in the alternative claimed for rectification or correction of the mistakes to give effect to the parties’ intentions.

DECISION

The judge, Richard Salter QC, held that the mistakes in the guarantee were so fundamental and extensive that they could not be sufficiently cured, either by way of a purposive reading of the contract as to its true construction, or by way of rectification. The guarantee was therefore ineffective as a matter of contract, and in any event would have been unenforceable because it failed to satisfy the requirements under the 1677 Act.

ANALYSIS

It was not disputed that the general contractual approach to construction should be applied to a contract of guarantee, and the objective approach was therefore applied. Salter QC stated that due to the sheer length and catalogue of the mistakes, to give effect to the guarantee would go beyond interpretation of the contract terms, and ‘would instead be writing a new and different contract for the parties’. Salter QC added that it was not the function of the court to write a new contract for the parties under the guise of interpreting an existing one.2

With regard to rectification, Salter QC considered the statements by Lord Denning that, ‘rectification is concerned with contracts and documents, not with intentions’, and that:

‘You do not look at the inner minds of the parties… you look at their outward acts, that is, what they said or wrote to one another in coming to their agreement, and then compare it with the document which they have signed. If you can predict with certainty what their contract was, and that it is, by a common mistake, wrongly expressed in the document, then you rectify the document’.3

Salter QC stated that there was no evidence whatsoever, other than the guarantee itself, of the terms intended to be included by the parties. It was therefore possible to assess the intentions of a reasonable person, but not the intentions of the actual parties. The claim for rectification therefore failed to overcome the high evidential burden due to lack of evidence of pre-contract negotiations to ascertain the intention of the parties on a subjective basis. The evidential burden in Fairstate was especially high because the guarantee was ‘substantially inapposite to the transaction’ for which it was intended, and would therefore require rectification of the substance of the contract, rather than specific details.

COMMENT

Fairstate highlights the importance of effectively documenting pre-contract negotiations to clearly demonstrate the parties’ intentions. It serves as a useful reminder that poor drafting and consequential mistakes will not always be remedied by the court. It also demonstrates how care should be taken with selecting appropriate precedents when drafting a contract. Despite the diligence of contracting parties and legal advisors, it is inevitable that in some instances contracts may be entered on the basis of a mistake. Therefore, it is essential to clearly demonstrate the terms that were intended to be included (or in some cases excluded) in the contract and their intended effect. As the approach of the court cannot be to dig down and assess with any certainty what either party actually intended, it will look at the actions of those parties. This should ensure that the remedy of rectification can be used as an aid rather than a hindrance.

Practical Tips

Ensure comprehensive notes are taken of all pre-contract negotiations.

Record any amendments to a draft contract in correspondence with the other party.

Mark all documents ‘subject to contract’ during pre-contract negotiations.

If you suspect the other party has made a mistake or has a different intention, make reasonable enquiries, and clarify the intention of each party in written correspondence.

Where there is a danger that a term of the contract is ambiguous, either negotiate to change the way it is worded, or at the very least, document your understanding of its meaning.

Avoid legally binding informal agreements, or agreements that vary the terms of a pre-existing contract, without documenting such variations.